Tax USA Assignment 3

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Week11.1_pope_phft2014_ind_pp_06.pptx

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Deductions and Losses

Chapter 6

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DEDUCTIONS AND LOSSES (1 of 2)

Classifying deductions as for vs. from adjusted gross income

Criteria for deducting business and investment expenses

General restrictions on the deductibility of expenses

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DEDUCTIONS AND LOSSES (2 of 2)

Proper substantiation requirement

When an expense is deductible

Special disallowance rules

Tax planning considerations

Compliance and procedural considerations

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Classifying Deductions for Adjusted Gross Income (1 of 2)

Taxpayer benefits from deduction even if she claims the std. deduction

Reducing AGI: +/- benefits for t/p

+ Many deductions and credits phased out above certain AGI thresholds

+ Reduces AGI floors for certain categories of itemized deductions

- Reduces certain deduction ceilings

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Classifying Deductions for Adjusted Gross Income (2 of 2)

Most common deductions for AGI

Trade or business expenses

IRAs and qualified pension contributions

Alimony

Losses on sale of bus/invest property

Moving expenses

Int. paid on qualified education loans

½ of self-employment tax

Health insurance paid by self-employeds

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Classifying Deductions from Adjusted Gross Income

Itemized deduction only will have tax benefit if total deductions exceed the taxpayer’s standard deduction

Deduct the higher of the standard deduction or sum of itemized deductions

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Criteria for Deducting Bus. & Investment Expenses

Business or investment requirement

Ordinary expense

Necessary expense

Reasonable expense

Expenses and losses must be incurred directly by the taxpayer

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Business or Investment Activity (1 of 2)

Activity engaged in for profit

Use facts and circumstances test

Trade or business (ToB) vs. investment classification

ToB losses are ordinary losses

ToB expenses are for AGI

Investment losses are capital

Invest. exp are from AGI

Subject to 2% of AGI floor

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Business or Investment Activity (2 of 2)

Losses and expenses related to rents and royalties are for AGI deductions

Legal and accounting fees

For AGI deduction for ToB if incurred in ordinary course of business

Fees related to taxes also for AGI for ToB

Nonbusiness fees related to taxes from AGI deduction subject to 2% of AGI floor

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Ordinary Expense

Ordinary expense requirements

Reasonable in amount

Bear reasonable proximate relationship to income-producing activity or property

Must be customary or usual course of a particular industry or business community

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Necessary Expense

An expense is considered necessary if it is “appropriate and helpful” in the taxpayer’s business

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Reasonable Expense

Problems often occur with salaries for shareholder-employees of closely held businesses

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Expenses and Losses Must Be Incurred Directly by the Taxpayer

Generally, a taxpayer cannot take a deduction for a loss or expense of another person

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General Restrictions on the Deductibility of Expenses

Capitalization vs. expense deduction

Expenses related to exempt income

Not deductible

Expenditures contrary to public policy

Others specifically disallowed

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Capitalization vs. Expense Deduction

General capitalization requirements

Election to deduct currently

E.g., certain research and experimental expenditures, cost of qualified tangible personal property

Capitalization of deduction items

E.g., carrying charges on unproductive unimproved real estate

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Expenditures that Are Contrary to Public Policy

Cannot deduct illegal payments or pmt. resulting from an illegal act

Fines and penalties

Bribes and Kickbacks

Expenses from illegal trade or business are deductible if taxpayer reports income from activity

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Other Expenditures Specifically Disallowed (1 of 2)

Political contrib. & lobbying exp.

Bus. investigation & preopening exp.

Includes investment expenses

May immediately expense up to $5k

Deduction phased out $ for $ if > $50k

Amortize remainder over 180 months beginning when business commences

No amortization if business not begun

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Other Expenditures Specifically Disallowed (2 of 2)

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Proper Substantiation Requirement (1 of 2)

The taxpayer has the burden of proof

The Cohan rule

Certain expenses may be estimated

More restrictive substantiation requirements for travel, entertainment, business gifts

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Proper Substantiation Requirement (2 of 2)

Documentation requirements for travel, entertainment, gifts, etc.

Amount

Time and place of travel/entertainment

Date and description of gift

Business purpose

Business relationship

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When an Expense Is Deductible Cash Method (1 of 2)

Generally deductible when actually paid

Prepaid expenses

No current deduction if expenditure creates an asset with a life substantially beyond end of tax year

Exception for prepaid rent if prepmt ≤ 1 year and lease requires the prepmt

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When an Expense Is Deductible Cash Method (2 of 2)

Prepaid interest

Amortize over period of loan to which interest charge is allocated

Points deductible over life of loan

Points paid in connection w/purchase or improvement of a principal residence are currently deductible

See Topic Review 3

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When an Expense Is Deductible Accrual Method (1 of 2)

Allowed to deduct exp. in period in which exp. accrue under all-events test & economic performance test

All-events test (AET) met

Amount of liability is established

Amount of liability is determined with reasonable accuracy

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Economic performance test (EPT) is met when EP deemed to occur

Exception for recurring liabilities

All-events test met

EPT occurs w/in 8½ mo (or a reasonable period) after close of tax year

Exp. consistently treated as incurred in tax yr.

Item not material, or better matching w/AET

See Table 1

When an Expense Is Deductible Accrual Method (2 of 2)

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Special Disallowance Rules

Wash sales

Transactions between related parties

Hobby losses

Vacation home

Expenses of an office in the home

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Wash Sales

Wash sales occur when “substan-tially identical” stock or securities acquired by taxpayer w/in 61 days

Extends from 30 days before date of sale to 30 days after date of sale

Loss on wash sale disallowed

Disallowed loss added to basis of recently purchased stock or securities

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Transactions between Related Parties In General (1 of 2)

§267 defines related parties

Loss on transaction between related parties disallowed

Disallowed loss may be used to offset gain from subsequent sale to unrelated party

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Unpaid expenses

Accrual basis taxpayer cannot deduct expense to cash basis related party until cash basis party recognizes payment as income

Transactions between Related Parties In General (2 of 2)

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Alice and Beth equal partners in the AB Partnership

First Corp:

Beth owns 60%

Craig, Alice’s husband, owns 40%

Alice:

Considered to own Craig’s 40% of First Corp

Not considered to own Beth’s 60% because only owns by attribution

Can recognize loss if she sells First Corp because she is deemed to own < 50%

Transactions between Related Parties Example 33 (1 of 2)

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Transactions between Related Parties Example 33 (2 of 2)

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Same facts as in Example 33, except

First Corp owned

50% by AB Partnership

25% each by Beth and Craig

Alice considered to own 100% in First Corp

25% direct ownership

Craig’s 25% attributed due to marriage

AB’s 50% because she owns 50% of AB

Alice cannot recognize a loss on the sale of property to First Corp because she owns ≥ 50%

Transactions between Related Parties Example 34 (1 of 2)

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Transactions between Related Parties Example 34 (2 of 2)

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Hobby Losses (1 of 4)

Activity has more personal attributes than profit motive

IRS profit motive factors

Activity conducted in businesslike manner

Expertise of taxpayer or advisors

Time and effort expended

Expected asset appreciation

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Hobby Losses (2 of 4)

IRS factors (cont’d)

Taxpayer’s success in similar activities

Profits earned and profit history

Taxpayer’s financial status

Personal pleasure or recreation in activity

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Hobby Losses (3 of 4)

Profit motive assumed if activity profitable in 3 of 5 years

Three tiers of expenses

Deductible even if no hobby exists

Deductible if activity was for profit

But do not reduce basis of any assets

Deductible if activity was for profit

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Hobby Losses (4 of 4)

Deductible hobby expenses

Hobby-related expenses deductible up to gross income of hobby activity

Deductible as miscellaneous itemized deductions subject to 2% of AGI floor

Special order of the deductions

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Vacation Home Dwelling Unit Defined

More expansive than §280A

Requirements

Provides shelter

Place for eating and sleeping

Includes cooking facilities and toilet

Boats and motor homes could qualify

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Vacation Home Rules for Deductibility (1 of 2)

Deductions on vacation home may be limited or disallowed

Vacation home if personal use greater of 14 days, or 10% of # of days property used as rental

Property rented < 15 days

No taxable inc. and no deductions

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Vacation Home Rules for Deductibility (2 of 2)

Personal days< 15 days

Regular rental rules apply instead of

§280A vacation home rules do not apply

Expenses allocated based on days of use

# of rental days

Total # of days used

Total expenses

for the year

Rental use

expenses

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Expenses of an Office in the Home

Office in the home expenses

Deductible only if office regularly and exclusively used for business AND

Principal place of taxpayer’s business OR a place where TP meets with clients

Employees must also use office for convenience of employer

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Tax Planning Considerations

Hobby losses

Control timing of hobby losses

Unreasonable Compensation

If IRS feels that a salary payment to an officer is excessive

Often recharacterize excess portion as a dividend

Timing of deductions

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Schedule C for sole proprietorship

Schedule E for rents and royalties

Other investment expenses reported on Schedule A Proper substantiation

IRS scrutiny

Statutory requirements

Travel and ent are of particular interest to the IRS

Compliance & Procedural Considerations (1 of 2)

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Business vs. hobby

Form 8829 to claim home office deduction on Schedule C

Form 2106 to claim home office deduction by employees

Taxpayer may be willing to extend statute of limitation’s period to prove profit motive by filing Form 5231

Compliance & Procedural Considerations (2 of 2)

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END Chapter 6

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